Monday, August 10, 2015

The two
most common methods to value an income producing property is to look at the
Gross Rent Multiplier (GRM) or the Capitalization Rate (Cap Rate). The purpose
of this analysis is to define these common valuation methods and expand on the cap
rate method.

Gross
Rent Multiplier

The GRM is calculated by dividing the purchase
price by the annual gross scheduled income.

Formula:

Formula:

The GRM
method is an easy way to compare properties because the numbers cannot really
be manipulated, unlike net income. Even if the property were vacant,
calculating a gross income using market rents is relatively easy. There are
times that a real estate agent might overestimate gross income or pro forma
income, but generally speaking, the gross scheduled income is a straight
forward number. When comparing groups of properties, the lower the GRM, the
better the deal, generally. The downside to this method is that it does not
take into account the costs to own the property which includes normal expenses,
maintenance, and vacancies.

Capitalization
Rate

The cap
rate is calculated by dividing the net operating income (NOI) by the price.

Formula:

Formula:

When
searching for properties in the various databases such as the Multiple Listing
Service, Costar, or Loopnet, a parameter could be that the only acceptable
property would be properties with a greater than 8% cap rate. When a
prospective property is found, you then re-create the net income calculation.

Example:
$1,000,000 Purchase Price

Sellers
Operating Statement

Adjusted
Operating Statement

Gross
Income:

Property
Taxes:

Insurance:

Utilities:

Maintenance:

Vacancy
Allowance:

Reserve:

Management:

Net
Income:

Capitalization
Rate:

$100,000

$4,500
(Seller’s Tax Amount)

$2,000

$3,500

$10,000

$80,000

8.00%

$100,000

$12,500
(1.25% of Purchase Price)

$2,000

$3,500

$10,000

$5,000
(5.0% of rents)

$2,500
($250/Door)

$3,000

$61,500

6.15%

If your
search parameter was to only see properties with an 8.0% cap rate or above,
this property would show in the search results and after due diligence, the cap
rate would end up being too low. Many buyers and sellers look at the above
adjustments and argue that the vacancy allowance was too high or that they were
going to manage the property themselves. These are valid comments and removing
the management expense would result in a higher NOI, but the adjusted operating
statement is how a bank would look at it and even though your expenses, as a
buyer, would be lower. It is important to think about your financing options
when considering what to pay for a property.

Capitalization
Rate – Gordon Growth Model

In
financial theory, a perpetuity is a set of cash flows that will continue into
infinity and the formula is identical to the formula defined above for the cap
rate method. The valuation method treats the income received by the property as
income that will continue forever; however, there would be some amount of
expected growth. As an owner of an apartment complex or office building, it
would not be proper to assume that the cash flows from that building will
remain constant into infinity.

The Gordon Growth Model is commonly used to
value the intrinsic value of stock or firm.

Formula using Dividends:

Formula using Free Cash Flows:

rE = Required Rate of Return
G = Growth Rate
D = Dividends

Example:

rE = Required Rate of Return
G = Growth Rate
D = Dividends

Example:

As you
might imagine, there were several assumptions made in the above example, but
this is how cash flows are valued. This growth model is appropriate for real
estate as well.

Net
Income:

Cap
Rate:

Growth
Rate:

Value:

$100,000

8.0%

0.0%

$1,250,000

$100,000

8.0%

1.0%

$1,428,571

$100,000

8.0%

2.0%

$1,666,667

$100,000

8.0%

3.0%

$2,000,000

The key is
to determine an appropriate growth rate.

In
commercial leases, there are typically built-in rent increases. If you have a
five unit retail center, long term tenants, and a 3% annual increase for each
lease, a 3% growth rate might be appropriate. That could be overly optimistic,
but for any piece of investment real estate, assuming a 0% growth rate is not
intuitively valid. Even when leases do not have built-in rent increases,
inferring a growth rate is valid, even if it is a nominal number.

By analyzing income properties with this method,
there would be more opportunities available and the valuation would be more
accurate. However, it should be noted that banks would not finance a property
using a valuation done with this method. The reason being is that a bank would
be looking at a relatively short term period, 5 – 10 years. This valuation
would help an investor decide on a good investment based on anticipated growth.